How municipal bonds work
A bond is a debt instrument. Municipal bonds pay interest, usually semi-annually. The bond investor is repaid the face amount of the bond on the maturity date. The interest rate, payment dates, and maturity date are all stated in the bond indenture – the legal document for a bond issue.
A face amount for a municipal bond is typically $1,000. Investors buy bonds in multiples of $1,000. So, $50,000 in face amount can be thought of as “50 bonds”. The investor may pay more or less than $1,000 for the bond, depending on the market value. At maturity, however, the investor is always repaid the face amount of the bond. The difference between the face amount of the bond and the price paid may generate a gain or loss for the investor at maturity.
Federally tax-exempt interest
Taxpayers report interest and dividend income on Schedule B of the individual tax return (Form 1040). Schedule B is required if the total interest and dividends earned for the year is above a specific dollar amount. For tax year 2014, that amount is $1,500.
Interest is reported to taxpayers on Form 1099-INT. The bond issuer is obligated to send this form to investors who own their municipal bonds. Typically, a third party registrar or custodian sends the 1099-INT on the issuer’s behalf.
IRS Publication 17 addresses municipal bonds. You can find the publication at www.irs.gov. The publication states that “interest on bond used to finance government operations is generally not taxable” if the bond is issued by a state or other political subdivision.
Interest on these types of municipal bonds is excluded from Schedule B. If the amount is excluded, it may not be federally taxable.
Mortgage revenue bonds, private activity bonds
Other types of municipal bonds may generate taxable interest. IRS Publication 550 provides more detail on municipal bond taxation. Mortgage revenue bonds and private activity bonds may be taxable. When purchasing municipal bonds, ask your financial advisor to explain the type of municipal bond you’re purchasing.
Alternative minimum tax (AMT)
Alternative minimum tax (AMT) may require the taxpayer to make a second calculation of their tax liability. That second calculation adds back certain income that is tax-exempt on the initial tax calculation. Some types of municipal bond income are added to the AMT calculation.
AMT is calculated on IRS Form 6251. When required, the taxpayer calculates their tax liability using Form 6251. If the AMT tax liability is higher, the taxpayer may pay tax based on the higher AMT liability. A CPA or tax preparer can review your 1099-INT and other tax documents to determine if you are subject to AMT.
Your municipal bond may also be exempt from state income tax, as well as federal income tax. Every individual’s tax situation is different. Consult a CPA or tax preparer to understand your reporting requirements for municipal bond interest.